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Statement by

Alan Greenspan

Chairman, Board of Governors of the Federal Reserve System

Submitted to the

Committee on Banking, Finance and Urban Affairs

U

S

House of Representatives

February 7, 1989

Mr

Chairman, I am pleased to address issues raised by recent

trends in corporate restructuring activity

The spate of mergers,

acquisi- tions[acquisitions],leveraged buyouts, share repurchases, and divestitures
in recent years is a significant development

It has implications for

share- holders, the efficiency of our companies, employment and
investment, financial stability, and, of course, tax revenues and our
tax system

While the evidence suggests that the restructurings of the

1980s probably are improving, on balance, the efficiency of the American
economy, the worrisome and possibly excessive degree of leveraging
associated with this process could create a set of new problems for the
financial system.
Corporate restructuring is not new to American business

It

has long been a feature of our enterprise system, a means by which firms
adjust to ever-changing product and resource markets, and to perceived
opportunities for gains from changes in management and management
strategies.
Moreover, waves of corporate restructuring activity are not
new

We experienced a wave of mergers and acquisitions around the turn

of this century and again in the 1920s

In the postwar period, we

witnessed a flurry of so-called conglomerate mergers and acquisitions in
the late 1960s and early 1970s
However, the 1980s have been characterized by features not
present in the previous episodes

The recent period has been marked not

only by acquisitions and mergers, but also by significant increases in
leveraged buyouts, divestitures, asset sales, and share repurchase
programs

In many cases, recent activity reflects the break-up of the

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big conglomerate deals packaged in the 1960s and 1970s

Also, the

recent period has been characterized by the retirement of substantial
amounts of equity (more than $500 billion since 1983) mostly financed by
borrowing in the credit markets
The accompanying increase in debt has resulted in an
appreciable rise in leverage ratios for many of our large corporations
Aggregate book value debt-equity ratios, based on balance sheet data for
nonfinancial firms, have increased sharply in the 1980s, moving outside
their range in recent decades, although measures based on market values
have risen more modestly
Along with this debt expansion, the ability of firms in the
aggregate to cover interest payments has deteriorated

The ratio of

gross interest payments to corporate cash flow before interest provision
is currently around 35 percent, close to the 1982 peak when interest
rates were much higher

Moreover, current interest coverage rates are

characteristic of past recession periods, when weak profits have been
the culprit

Lately profits have been fairly buoyant, the current

deterioration has been due to heavier interest burdens.
A measure of credit quality erosion is suggested by an
unusually large number of downgradings of corporate bonds in recent
years

The average bond rating of a large sample of firms has declined

since the late 1970s from A+ to ACauses of Restructuring Activity
To fashion an appropriate policy response, if any, to this
extraordinary phenomena, there are some key questions that must be
answered

What is behind the corporate restructuring movement9

Why is

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it occurring now, in the middle and late 1980s, rather than in some
earlier time? Why has it involved such a broad leveraging of corporate
balance

sheets?

And finally, has it been good or bad for the American

economy?
The 1980s has been a period of dramatic economic changes, large
swings in the exchange value of the dollar, with substantial
consequences for trade-dependent industries, rapid technological
progress, especially in automation and telecommunications, rapid growth
in the service sector, and large movements in real interest rates and
relative prices

Clearly, such changes in the economic environment

imply major, perhaps unprecedented, shifts in the optimal mix of assets
at firms—owing to corresponding shifts in synergies--and new
opportunities for improving efficiency

Some activities need to be shed

or curtailed, and others added or beefed up

Moreover, the long period

of slow productivity growth in the 1970s may have partly exacerbated the
buildup of a backlog of inefficient practices
When assets become misaligned or less than optimally managed,
there is clearly an increasing opportunity to create economic value by
restructuring companies, restoring what markets perceive as a more
optimal mix of assets

But restructuring requires corporate control

And managers, unfortunately, often have been slow in reacting to changes
in their external environment, some more so than others

Hence, it

shouldn't be a surprise that, in recent years, unaffiliated corporate
restructurers, some call them corporate raiders, have significantly bid
up the control premiums over the passive investment value of companies
that are perceived to have suboptimal asset allocations

If a company

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has an optimal mix there is no economic value to be gained from
restructuring and, hence, no advantage in obtaining control of a company
for such purposes

In that case, there is no incentive to bid up the

stock price above the passive investment value based on its existing,
presumed optimal, mix of assets

But in an economy knocked partially

off kilter by real interest rate increases and gyrations in foreign
exchange and commodity prices, there emerge significant opportunities
for value-creating restructuring at many companies
This presumably explains why common stock tender offer prices
of potential restructurings have risen significantly during the past
decade

Observed stock prices generally (though not always) reflect

values of shares as passive investments

But there are, for any

individual company, two or more prices for its shares, reflecting the
degree of control over a company's mix of assets
Tender-offer premiums over passive investment values presumably
are smaller than control premiums to the extent that those making tender
offers believe that, restructured, the value of shares is still higher
than the tender

Nonetheless, series on tender-offer premiums afford a

reasonable proxy of the direction of control premiums
Such tender-offer premiums ranged from 13 to 25 percent in the
1960s, but have moved to 45 percent and higher during the past decade,
underscoring the evident increase in the perceived profit to be gained
from corporate control and restructuring
Interest in restructuring also has been spurred by the apparent
increased willingness and ability of corporate managers and owners to
leverage balance sheets.

The gradual replacement of managers who grew

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up in the Depression and developed a strong aversion to bankruptcy risk
probably accounts for some of the increased proclivity to issue debt
now
Moreover, innovations in capital markets have made the
increased propensity to leverage feasible

It is now much easier than

it used to be to mobilize tremendous sums of debt capital for leveraged
purchases of firms

Improvements in the loan-sale market among banks

and the greater presence of foreign banks in U S

markets have greatly

increased the ability of banks to participate in merger and acquisition
transactions

The phenomenal development of the market for low-grade

corporate debt, so-called "junk bonds," also has enhanced the
availability of credit for a wide variety of corporate transactions
The increased liquidity of this market has made it possible for
investors to diversify away firm-specific risks by building portfolios
of such debt
The tax benefits of restructuring activities are, of course,
undeniable, but this is not a particularly new phenomenon

Our tax

system has long favored debt finance by taxing the earnings of corporate
debt capital only at the investor level, while earnings on equity
capital are taxed at both the investor and corporate levels

There have

been other sources of tax savings in mergers that do not depend on debt
finance, involving such items as the tax basis for depreciation and
foreign tax credits

And taxable owners benefit when firms repurchase

their own shares, using what is, in effect, a tax-favored method of
paying cash dividends

In any event, the recent rise in restructuring

activity is not easily tied to any change in tax law

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Evidence about the economic consequences of restructuring is
beginning to take shape, but much remains conjectural

It is clear that

the markets believe that the recent restructurings are potentially
advantageous

Estimates range from $200 billion to $500 billion or more

in paper gains to shareholders since 1982

Apparently, only a small

portion of that has come at the expense of bondholders

These gains are

reflections of the expectations of market participants that the
restructuring will, in fact, lead to a better mix of assets within
companies and greater efficiencies in their use

This, in turn, is

expected to produce marked increases in future productivity and, hence,
in the value of American corporate business

Many of the internal

adjustments brought about by changes in management or managerial
policies are still being implemented, and it will take time before they
show up for good or ill in measures of performance
So far, various pieces of evidence indicate that the trend
toward more ownership by managers and tighter control by other owners
and creditors has generally enhanced operational efficiency.

In the

process, both jobs and capital spending in many firms have contracted as
unprofitable projects are scrapped

But no clear trends in these

variables are yet evident in restructured firms as a group

For the

business sector, generally, growth of both employment and investment has
been strong
If what I've outlined earlier is a generally accurate
description of the causes of the surge in restructurings of the past
decade, one would assume that a stabilization of interest rates,
exchange rates, and product prices would slow the emergence of newly

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misaligned companies and opportunities for further restructuring

Such

a development would presumably lower control premiums and reduce the
pace of merger, acquisition, and LBO activity
This suggests that the most potent policies for defusing the
restructuring boom over the long haul are essentially the same
macroeconomic policies toward budget deficit reduction and price
stability that have been the principal policy concerns of recent years
Financial Risks
Whatever the trends in restructuring, we cannot ignore the
implications that the associated heavy leveraging has for broad-based
risk in the economy

Other things equal, greater use of debt makes the

corporate sector more vulnerable to an economic downturn or a rise in
interest rates
be affected

The financial stability of lenders, in turn, may also
How much is another question

The answer depends greatly

on which firms are leveraging, which financial institutions are lending,
and how the financings are structured
Most of the restructured firms appear to be in mature, stable,
non-cyclical industries

Restructuring activity has been especially

prevalent in the trade, services, and, more recently, the food and
tobacco industries

For such businesses, a substantial increase in debt

may raise the probability of insolvency by only a relatively small
amount

However, roughly two-fifths of merger and aquisition activity,

as well as LBOs, have involved companies in cyclically sensitive
industries that are more likely to run into trouble in the event of a
severe economic downturn

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Lenders to leveraged enterprises have been, in large part,
those that can most easily absorb losses without major systemic
consequences

They include mutual funds, pension funds, and insurance

companies, which generally have diversified portfolios, have
traditionally invested in securities involving some risk, such as
equities, and are not themselves heavily leveraged.

To the extent that

such debt is held by individual institutions that are not well
diversified, there is some concern

At the Federal Reserve, we are

particularly concerned about the increasing share of restructuring loans
made by banks.

Massive failures of these loans could have broader

ramifications
Generally, we must recognize that the line between equity and
debt hag become increasingly fuzzy in recent years

Convertible debt

has always had an intermediate character, but now there is almost a
continuum of securities varying in their relative proportions of debt
and equity flavoring

Once there was a fairly sharp distinction between

being unable to make interest payments on a bond, which frequently led
to liquidation proceedings, and merely missing a dividend
distinction is much smaller

Now the

Outright defaults on original issue high-

yield bonds have been infrequent to date, but payment difficulties have
led to more frequent exchanges of debt that reduce the immediate cash
needs of troubled firms

Investors know when they purchase such issues

that the stream of payments received may well differ from the stream
promised, and prices tend to move in response to changes in both debt
and equity markets

In effect, the yields on debt capital rise toward

that of equity capital when scheduled repayments are less secure.

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Policy Implications
In view of these considerations, and the very limited evidence
on the effects of restructuring at the present time, it would be unwise
to arbitrarily restrict corporate restructuring

We must resist the

temptation to seek to allocate credit to specific uses through the tax
system or through the regulation of financial institutions.
Restrictions on the deductibility of interest on certain types of debt
for tax purposes or on the granting of certain types of loans
unavoidably involve an important element of arbitrariness, one that will
affect not only those types of lending intended but other types as well
Moreover, foreign acquirers could be given an artificial edge to the
extent that they could avoid these restrictions

Also, the historical

experience with various types of selective credit controls clearly
indicates that, in time, borrowers and lenders find ways around them
All that doesn't mean that we should do nothing

The degree of

corporate leveraging is especially disturbing in that it is being
subsidized by our tax structure

To the extent that the double taxation

of earnings from corporate equity capital has added to leveraging, debt
levels are higher than they need, or should, be

Our options for

dealing with this distortion are, unfortunately, constrained severely by
the federal government's still serious budget deficit problems

One

straightforward approach to this distortion, of course, would be to
substantially reduce the corporation income tax

Alternatively, partial

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mtegration of corporate and individual income taxes could be achieved
by allowing corporations a deduction for dividends paid or by giving
individuals credit for taxes paid at the corporate level

But these

changes taken alone would result in substantial revenue losses.

A rough

estimate of IRS collections from taxing dividends is in the $20 to $25
billion range
Dangers of risk to the banking system associated with high debt
levels also warrant attention

The Federal Reserve, in its role as a

supervisor of banks, has particular concerns in this regard

In 1984,

the Board issued supervisory guidelines for assessing LBO-related loans,
which are set forth in an attachment to my text

The Federal Reserve is

currently in the process of reviewing its procedures regarding the
evaluation of bank participation in highly leveraged financing
transactions

The circumstances associated with highly leveraged deals

require that creditors exercise credit judgment with special care
Doing so entails assessing those risks that are firm-specific as well as
those common to all highly leveraged firms

ATTACHMENT

The Federal Reserve's directive to examiners on leveraged
buyout loans, issued in 1984, provided the following supervisory
guidance to supplement standard loan review procedures

The nature of leveraged buyouts and, in particular, the level
of debt typically involved in such arrangements give rise to supervisory
concerns over the potential risk implications for bank loan portfolios
The high volume of debt relative to equity that is characteristic of
leveraged buyouts leaves little margin for error or cushion to enable
the purchased company to withstand unanticipated financial pressures or
economic adversity. Two principal financial risks associated with
leveraged buyout financing are (1) the possibility that interest rates
may rise higher than anticipated and thereby significantly increase the
purchased company's debt service burden, and/or (2) the possibility that
the company's earnings and cash flow will decline or fail to meet
projections, either because of a general economic recession or because
of a downturn in a particular industry or sector of the economy
While
either one of these developments can undermine the creditworthiness of
any loan, the high degree of leverage and the small equity cushion
typical of most leveraged buyouts suggest that economic or financial
adversity will have a particularly large and negative impact on such
companies
Thus, a leveraged buyout arrangement that appears reasonable
at a given rate of interest or expected cash flow can suddenly appear to
be questionable if interest rates rise significantly or if earnings
should fail to provide an adequate margin of coverage to service the
acquisition debt
In addition to unfavorable interest rate movements and earnings
developments, adverse economic conditions may also have a negative
impact on the value of a company's collateral. For example, if a
general economic slowdown reduces a company's sales and earnings, the
marketability and value of its collateral may also suffer
In any
event, given the amount of debt involved in leveraged buyouts, the value
of collateral is extremely important, and the risk that collateral
coverage may be insufficient to protect the bank is a significant factor
in evaluating the creditworthiness of these loans
In light of all of
these considerations, the quality of a purchased company's management is
also extremely important and represents another critical element in the
bank's evaluation of leveraged buyouts
This is because such management
must oversee both the special financial risks associated with the
leveraged buyout form of acquisition financing as well as the normal
day-to-day affairs and operations of the purchased company's business
In the course of on-site examinations, examiners should review
a bank's involvement in leveraged buyout financing as well as the loans
associated with individual leveraged buyouts
The following general

guidelines are provided to underscore and supplement existing loan
review procedures
1

In evaluating individual loans and credit files, particular
attention should be addressed to i) the reasonableness of
interest rate assumptions and earnings projections relied
upon by the bank in extending the loan, ii) the trend of the
borrowing company's and the industry's performance over time
and the history and stability of the company's earnings and
cash flow, particularly over the most recent business cycle,
iii) the relationship between the company's cash flow and
debt service requirements and the resulting margin of debt
service coverage, and iv) the reliability and stability of
collateral values and the adequacy of collateral coverage

2. In reviewing the performance of individual credits,
examiners should attempt to determine if debt service
requirements are being covered by cash flow generated by the
company's operations or whether the debt service
requirements are being met out of the proceeds of additional
or ancillary loans from the bank designed to cover interest
changes
3

Policies and procedures pertaining to leveraged buyout
financing should be reviewed to ensure that they incorporate
prudent and reasonable limits on the total amount and type
(by industry) of exposure that the bank can assume through
these financing arrangements

4

The bank's pricing, credit policies, and approval procedures
should be reviewed to ensure i) that rates are reasonable in
light of the risks involved and ii) that credit standards
are not compromised in order to increase market share.
Credit standards and internal review and approval standards
should reflect the degree of risk and leverage inherent in
these transactions

5

Total loans to finance leveraged buyouts should be treated
as a potential concentration of credit and if, in the
aggregate, they are sufficiently large in relation to
capital, the loans should be listed on the concentrations
page in the examination report

6

Significant deficiencies or risks regarding a bank's
leveraged buyout financing should be discussed on page 1 of
the examination report and brought to the attention of the
board of directors